Fixed Income-II

Fixed Income - II
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Mapping to Curriculum
 Reading 42: Introduction to Asset-backed Securities

 Reading 43: Fixed Income: Analysis of Risk
 Reading 44: Fundamentals of Credit Analysis

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc. 2
Reading 42: Introduction to Asset-backed Securities

Learning Outcomes
The candidate should be able to:

a. Explain benefits of securitization for economies and financial markets;
b. Describe securitization, including the parties involved in the process and the roles they play;
c. Describe typical structures of securitizations, including credit tranching and time tranching;
d. Describe types and characteristics of residential mortgage loans that are typically securitized;
e. Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-
through securities and collateralized mortgage obligations, and explain the cash flows and risks for each
type;
f. Define pre-payment risk and describe the pre-payment risk of mortgage-backed securities;
g. Describe characteristics and risks of commercial mortgage-backed securities;
h. Describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and
risks of each type;
i. Describe collateralized debt obligations, including their cash flows and risks.
j. Describe characteristics and risks of covered bonds and how they differ from the other asset backed
securities.

How Securitization Works
An Example of a Securitization (asset backed securities)
1. Sale of medical
Mediquip equipment financed Customers
by loans
3. Cash payments 2. Sale of the 6. Periodic cash

for the loans loans payments
Medical Equipment Trust (MET)
4. Issuance and 5. Cash payment 6. Periodic cash

sale of securities for securities payments
Investors

How Securitization Works (Cont.)
 An Example of a Securitization (Mediquip)

• Let’s suppose there is a company called Mediquip, that manufactures medical equipment.
• It sells its equipment through loans (maturity of 5 years and fixed interest rate) granted by the company to its
customers, and the medical equipment serves as collateral for the loans.
• The loans are fully amortizing with the monthly payments (which includes principal and interest) repaid in 60
loan payments.
• The credit department decides whom to grant the loan and administers different aspects of loan including the
collection of payments from borrowers, notifying borrowers who may be delinquent, and recovering and
disposing of the medical equipment if the borrower defaults.
• Let’s see how the loans are securitized: Assume that the total loan granted by Mediquip is $100 million, which is
shown as an asset on the balance sheet.
• Since, the $100 million loan will be paid off to Mediquip approximately in 5 years, and if the company wants to
raise money before 5 years, it can do it through raising debt, bank loan, or securitization.
• As the treasurer of Mediquip is aware of the low funding costs of securitization, he decides to raise the money by
securitizing the loans instead of corporate bonds.
• In order to do the same, the company sets up a separate legal entity called Medical Equipment Trust (MET). It
sells the loans to this legal entity referred to as a Special Purpose Entity (SPE) and sometimes also called a
Special Purpose Vehicle (SPV) or a Special Purpose Company (SPC).
• MET issues and sells securities that are backed by the pool of securitized loans and receives cash.

 An Example of a Securitization (Mediquip) Cont.

• MET is legally independent and is considered bankruptcy remote from the seller of the loans. This means that if
Mediquip files bankruptcy, the loans backing the ABS that are issued by MET are secure within the SPE and the
creditors of Mediquip have no claim on them.
• The cash payments (including principal and interest) that are received from the collateral are used to make the
periodic cash payments to the security holders (the owners of ABS).
 Parties to a Securitization and their Roles:
• The seller of the collateral (Mediquip);

• The SPE (MET) that purchases the loans from Mediquip and uses them as collateral to issue the ABS; and
• The servicer of the loans (the servicing department of Mediquip).
• Third parties:
‒ This includes the independent accountants, lawyers/attorneys, trustees, underwriters, rating agencies, and
financial guarantors.

 Structure of a Securitization –
Bond Class Par Value (US$ millions)
A (senior) 180
B (subordinated) 14
C (subordinated) 6
Total 200
• This structure has more than one bond class or tranche. The bond classes differ as to how they will share any
losses resulting from the defaults of the borrowers, whose loans are in the collateral. The sharing of losses from
defaults differ. This structure is called subordination or credit tranching.
‒ For example, in the above structure, if the creditors do not pay their instalments, all losses are absorbed by
Bond Class C before any losses are realized by Bond Class B and then Bond Class A.
‒ Another aspect is that if the interest rates decline, the borrowers will try to pay off their loans and refinance
at lower interest rates. In return it will case the holders of ABS securities to be exposed to pre-payment risk
which will further lead to reinvestment risk. If any pre-payments come, it will first be distributed to Class C,
then Class B, and lastly to the senior class (Class A).

 Key Role of the Special Purpose Entity –

• An obvious question is about the reason due to which a securitization cheaper than a corporate bond issue, is
secured by the same collateral.
• The answer is that the SPE would not be affected by the bankruptcy of the originator (like Mediquip).
• For the same reason, the SPE would not be affected even if the originator (Mediquip) has a lower credit rating.
The SPE would still secure a higher credit rating and can sell the ABS securities at a lower spread thereby
reducing the cost of raising funds.

Benefits of Securitization for Economies and Financial Markets
 Benefits for Investors:

• It allows the investors to gain exposure to loans of the originator which could be a bank or a company like
Mediquip.
• It helps to hold direct legal claims on loans that enables these investors to tailor customize interest rate and
credit risk exposures to suit their needs.
• The ratings of MBS and ABS securities has been high historically, and the ratings have shown resilience in the
past.
 Benefits for Originators:
• The banks or companies like Mediquip can improve their profitability by increasing loan origination. They can
lend more with the help of securitization and further grow their businesses.
• By allowing banks to increase lending, securitization ultimately benefits individuals, governments, and
companies that need to borrow.
• It provides an alternative means of funding operations in addition to the bond, preferred equity, and common
equity issuance.
 Benefits for Economy:
• By making loans, securitization makes financial markets more efficient. It also improves liquidity in the financial
system. It helps transform illiquid assets on the bank’s balance sheet into liquid assets.
• It brings financial and capital markets closer. The banks that are a part of the financial markets issue securities,
which are ultimately by investors in the capital markets.

Example Problem
Agnelli Industries (Agnelli), a manufacturing of the industrial machine tools based in Bergamo, Italy, has €500
million worth of corporate bonds outstanding. These bonds have a credit rating below the investment grade.
Agnelli has €400 million of receivables on its balance sheet that it would like to securitize. The receivables
represent payments that Agnelli expects to receive for machine tools that it has sold to various customers in
Europe. Agnelli sells the receivables to the Agnelli trust, a special purpose entity. Agnelli trust then issue ABS,
backed by the pool of receivables, with the following structure:
Bond Class Par Value (€ millions)
A (senior) 280
B (subordinated) 60
C (subordinated) 60
Total 400
Bond Class A is given an investment-grade credit rating by the credit-rating agencies.

If Agnelli’s industries files for bankruptcy after the issuance of the asset-backed security:
A. Bond Classes A, B, and C will be unaffected
B. Bond Class A, B, and C will lose their entire par value
C. Losses will be realized by Bond Class C first, then by Bond Class B, and then by Bond Class A
Solution
The correct answer is C.

Whenever there are losses, it is first absorbed by Sub-ordinated debt holders i.e., Bond C class. Any losses
remaining are then absorbed by Bond Class B and lastly by Bond class A.

Residential Mortgage Loans
 Residential Mortgage Loan: This is the loan secured by the collateral of some specified real estate property
that obliges the borrower to make a pre-determined series of payments (generally includes principal and
interest) to the lender.
• Generally, the amount of loan advanced is less than the property’s value. This ratio is called Loan to Value ratio
(LTV ratio). The lower the LTV, the higher the borrower’s equity. It is less likely that the borrower is going to
default.
• In the United States, there are two types of mortgages based on the credit quality of the borrower—prime loans
and sub-prime loans.
‒ Prime loans: In this case, the borrower must have high credit quality in terms of employment, credit histories
and income;
‒ Sub-prime Loans: Here, the borrower has a lower credit quality in terms of employment, income, etc.
• Maturity: In the United States, the typical maturity of a mortgage is between the range of 15–30 years, while in
Europe, typically the maturity is between 20–40 years.
• Interest Rate Determination: Generally there are four ways of specifying the mortgage rate as follows—fixed
rate, adjustable or variable rate, initial period fixed rate, and convertible rate.

Residential Mortgage Loans (Cont.)
• Amortization Schedule: It is the gradual reduction of the amount borrowed over time—when the borrower pays
EMI. This schedule includes fully amortizing loans, partially amortizing loans, and interest only loan.
• pre-payment Options: A borrower may prepay all, or a part of the outstanding mortgage principal, prior to the
due date. This provision is called pre-payment option. For a lender, it is difficult to predict the amount and timing
of cash flows, thereby leading to reinvestment risk. This risk is referred to as the pre-payment risk.
• pre-payment Penalties: When a mortgage stipulates some sort of monetary penalty on pre-payment, it is
referred to as pre-payment of penalty mortgages.
• Rights of the Lender in a Foreclosure: Upon default, the lender can repossess the property and sell it.
However, the proceeds received from the sale may be insufficient to recover the losses.
‒ In case of recourse loan, the lender has a claim against the borrower’s other assets, if the proceeds from
selling the property are not sufficient.
‒ In case of non-recourse loan, the lender does not have such a claim, and thereby can look upon the
property to recover the outstanding mortgage balance.

Residential Mortgage-backed Securities
 Residential Mortgage-backed Securities: The bonds (mortgage-backed securities) created from the
securitization of mortgages (comprising of residential loans) are Residential Mortgage-backed Securities
(RMBS). In the United States, such securities are divided into two categories:
• Agency RMBS: These include securities issued by federal agencies, such as the Government National Mortgage
Association (popularly known as Ginnie Mae).
• Non-agency RMBS: Securities issued by any other institutions apart from these are known as non-agency
RMBS.
 Mortgage Pass-through Securities: These securities are created when one or more mortgage-holders
formulate a pool of mortgages and sell shares or participation certificates in the pool (like a mutual fund).
• Pass-through rate: A mortgage pass-through security’s coupon or interest rate is called the pass-through rate.
The pass-through rate that the investor receives is said to be 'net interest' or 'net coupon’, as it deducts the
servicing and administrative charges.
• Weighted average coupon rate and maturity: Since all the mortgages that are included in a pool of securitized
mortgages might have a different mortgage rate and maturity, a Weighted Average Coupon rate (WAC) and a
Weighted Average Maturity (WAM) are determined by taking into consideration all the mortgages in the pool. On
the next page, we present an example showing how to find out the WAC and WAM.

A diagram showing the structure of Mortgage Pass-through Securities:
Mortgage 1 Investor 1
Mortgage 2 Investor 2
Pool
… …
Mortgage N Investor N
Pass-through securities backed by the pool

are issued to the investors.

Example Problem
An example on WAC and WAM:

Assume that a pool includes three mortgages with the following characteristics:
Outstanding Mortgage Balance Coupon Rate Number of Months to

Mortgage
(US$) (%) Maturity
1 1,000 5.1 34
2 3,000 5.7 76
3 6,000 5.3 88
The outstanding amount of three mortgages is US$10,000. Thus, the weights of Mortgages 1, 2, and 3 are 10%,
30%, and 60%, respectively.

Solution
The WAC is:

10% * 5.1% + 30% * 5.7% + 60% * 5.3% = 5.4%.
The WAM is:

10% * 34 + 30% * 76 + 60% * 88 = 79 months

 Pre-payment Risk: An investor who owns mortgage pass-through securities is uncertain about future cash
flows as these future cash flows depend on actual pre-payments. This is known as pre-payment risk. There
are two types of pre-payment risks:
• Contraction risk: When actual pre-payment is higher than the forecasted because of the decline of interest
rates, it is contraction risk. When the interest rates decline, homeowners will refinance at the now-available
lower interest rates. In this case, the mortgage backed security, will have a shorter maturity than was anticipated
at the time of purchase. A maturity shorter than what is expected will lead to reinvestment risk for the investor.
• Extension risk: It is a risk of lower pre-payments when the interest rates rise because homeowners are
unwilling to give up the benefits of a contractual interest rate that now looks low. Consequently, a security
backed by mortgages will typically have a longer maturity than expected. With the increase in interest rates, the
prices of securities would fall.

 Pre-payment Rate Measures: The two key pre-payment measures are as follows:
• Single Monthly Mortality rate (SMM): It shows the dollar amount of pre-payment expected for the month, as a
proportion of mortgage-balance after taking into consideration the scheduled principal repayment for the month.
An SMM of 0.5% means that 0.5% of the beginning mortgage balance is expected to be paid by the end of
the month.
• Conditional Pre-payment rate (CPR): It is the annualized SMM. For example, a CPR of 6% means that ~6% of
the outstanding mortgage balance at the beginning of the year is expected to be prepaid by the end of the year.

• Public Securities Association (PSA): The pattern describing pre-payment rates in terms of a pre-payment
pattern is referred to as PSA (expressed as a series of monthly pre-payment rates).
‒ 100 PSA: The standard for the PSA model is 100 PSA, which means that investors can expect pre-
payments to follow the PSA pre-payment benchmark.
 Benchmark means that pre-payments would be at a rate of 0.20% for the first month and would increase by
0.2% every month, until the first 30 months. After that, it would remain constant at 6% every month. A PSA
assumption greater than 100 PSA means that pre-payments are assumed to be faster than the standard,
and a PSA lower than 100 PSA means that pre-payments are assumed to be slower than the standard.

Residential Mortgage-backed Securities (Cont.)
• Non-agency Residential Mortgage-Backed Securities: Entities like thrift institutions, commercial banks, and
private conduits typically issue non-agency MBS. Private conduits (entity that pools mortgages and other loans)
may purchase non-conforming mortgages, pool them, and then sell mortgage pass-through securities whose
collateral is the underlying pool of non-conforming mortgages. Their credit risk is an important consideration as
they are not guaranteed by the government or by a GSE. There is some form of internal or external credit
enhancement that is necessary to make these securities attractive to investors as they are not guaranteed. The
common credit enhancements include subordination, or credit tranching, over-collateralization, and reserve
accounts, as explained in the earlier readings.
‒ The investors must consider two important components when dealing with non-agency RMBS: The
first is the assumed default rate for the collateral and the second is the recovery rate. Even though
the collateral may default, not all of the outstanding mortgage balance may be lost. The subsequent sale
of the recovered property may provide cash flows that will be available to pay the bondholders.

Commercial Mortgage-backed Securities
 Collateralized Mortgage Obligations (CMO): It is the re-structuring of securities that can help redistribute
the cash flows of mortgage-related products into different bond classes or tranches. Such classes or
tranches have different exposures to pre-payment risk, and thus are different risk–return patterns relative to
the mortgage-related product from which they were created. These restructured securities are referred to as
CMOs. Note that the creation of a CMO structure cannot eliminate or change pre-payment risk; it can
only distribute it into different bond classes. Some common CMO structures are as follows:
• Sequential-Pay CMO Structures: The rule here says first, distribute all principal payments to Tranche A, until
its principal is paid completely. Then distribute all the principal payments to Tranche B, until its principal balance
is zero, and so on.
Tranche Par Amount (US$ millions) Coupon Rate (%)

A 389 5.5
B 72 5.5
C 193 5.5
D 146 5.5
Total 800

Commercial Mortgage-backed Securities (Cont.)
Average Life (years)

Prepayment Rate Collateral Tranche A Tranche B Tranche C Tranche D
100 PSA 11.2 4.7 10.4 15.1 24.0
125 PSA 10.1 4.1 8.9 13.2 22.4
165 PSA 8.6 3.4 7.3 10.9 19.8
250 PSA 6.4 2.7 5.3 7.9 15.2
400 PSA 4.5 2.0 3.8 5.3 10.3
600 PSA 3.2 1.6 2.8 3.8 7.0
• If we assume that the pre-payment rate is 165 PSA, the mortgage pass-through security’s average life was 8.6
years. However, the actual PSA could be different than the assumed PSA, in which case the security’s average
will also be different. The variability of the average lives of the tranches remains a big problem that can be
resolved to a large extent by introducing Planned Amortization Class (PAC) tranches that is covered next.

• CMO Structures Including Planned Amortization Class and Support Tranches: A PAC tranche offers
greater predictability of the cash flows given that the pre-payment rate is within a specified band over the
collateral’s life. The reduction of pre-payment risk comes from the existence of non-PAC tranches or support
tranches.
‒ Until the pre-payment rate is within the specified band, called the PAC band, all pre-payment risk is
absorbed by the support tranche. However, if the pre-payments are slower than expected, the support
tranches do not receive any principal repayment, until the PAC tranches receive their scheduled principal
repayment that reduces the extension risk of the PAC tranches.
 Likewise, if the collateral pre-payments are faster than expected, then the support tranches absorb any
excess principal repayments. This ultimately reduces the contraction risk of the PAC tranches.
 Note that if the support tranches are paid off quickly due to higher pre-payments, they stop providing any
protection to the PAC tranches.
Tranche Par Amount (US$million) Coupon Rate (%)

P (PAC) 487.6 5.5
S (support) 312.4 5.5
Total 800.0

 This exhibit shows the average life of the PAC and support tranches, under various actual pre-payment
rates. Notice that between 100 PSA and 250 PSA, the average life of the PAC tranche is constant at 7.7
years. However, at the slower and faster PSA, the schedule is broken and the average life changes. Even
then, the variability in average life of the PAC tranche when compared with that of the support tranche is
much less.
• Other CMO Structures: It is also possible to construct a floating rate tranche even if the collateral pays a fixed
rate of interest. This is accomplished by constructing issuing floater and an inverse floater tranche. Because the
floating-rate tranche pays a higher rate when interest rates increase and the inverse floater pays a lower rate
when interest rates increase, they would offset each other. Thus, a fixed-rate tranche can be used to satisfy the
demand for a floating-rate tranche.
Average Life (years)

Prepayment Rate PAC Tranche (P) Support Tranche (S)
50 PSA 10.2 24.9
75 PSA 8.6 22.7
100 PSA 7.7 20.0
165 PSA 7.7 10.7
250 PSA 7.7 3.3
400 PSA 5.5 1.9
600 PSA 4.0 1.4

• Commercial Mortgage Backed Securities: Here the collateral is a pool of commercial mortgages on income-
producing properties, such as apartment buildings, office buildings, warehouses, shopping centers, hotels, and
health care facilities.
‒ Credit Risk: The two indicators of potential credit performance are the Loan-to-Value ratio (LTV) and the
Debt Service Coverage (DSC) ratio. The lower LTV ratio is considered better as it indicates the amount of
loan given against the property value. The DSC ratio is equal to the property’s annual net operating
income (NOI) divided by the debt service. A DSC ratio that exceeds 1.0 is considered sufficient to service
the debt.
‒ CMBS Structure: The credit-rating agencies determine the level of credit enhancement necessary to
achieve a desired credit rating. The losses arising from defaults are borne by the unrated tranche which is
called the 'first-loss piece,' 'residual tranche’, or 'equity tranche' first. There are two characteristics specific
to CMBS structures. These are as follows:
 Call Protection: An important feature that distinguishes CMBS from RMBS is the protection against early
pre-payments known as a call protection. The borrowers in the US do not pay any penalty for pre-payment
in case of residential mortgages. There are two types of call protections—at the structure level and at the
loan level.

‒ Pre-payment lockout: This is an agreement with the borrower that prohibits any pre-payments during a
specified period of time. The borrower is not allowed to make any pre-payments for a specified period of
time.
‒ Pre-payment penalty points: It is a predetermined penalty that a borrower must pay to prepay the loan.
‒ Yield maintenance charge: It is a penalty paid by the borrower that makes refinancing the loan at a lower
rate uneconomical for the borrower.
‒ Defeasance: Under this mechanism, the borrower has to provide sufficient funds to the servicer, so that it
can be invested in a portfolio of government securities that replicates the cash flows that would exist in the
absence of pre-payments.
• Balloon Maturity Provision: Balloon loans require a substantial principal repayment at maturity of the loan. The
lender may extend the loan over a period of time called the 'workout period' if the borrower fails to make the
balloon payment. At this stage, the lender may change the original terms of the loan and charge a higher interest
rate, called the 'default interest rate'.
‒ The risk of borrower defaulting on the balloon payment is called 'balloon risk.'

Non-mortgage Asset-backed Securities
 Non-mortgage ABS: There are various types of non-mortgage assets that have been used as collateral in
securitization like auto loan and lease receivables, credit card receivables, personal loans, and commercial
loans.
• Amortizing loans: The best examples of such loans are residential mortgages and auto loans. For example,
the cash flows for such loans consist of interest payments, scheduled principal repayments and any pre-
payments. For instance, if an ABS backed by a pool of 2,000 amortizing loans with a total par value of US$200
million. Some of the loans will be paid off overtime and the amounts received from such loans will be distributed
to the bond classes on the basis of the payment rule. As a result, the number of loans in the collateral will drop
from 2,000 and the total par value will fall to less than US$200 million.
• Non-amortizing loans: When there is no schedule for paying down the principal, the loan is non-amortizing.
Since there is no schedule for payments, ABS backed by non-amortizing loans is not affected by pre-payment
risk. For example – credit card receivables. Taking the same example as mentioned above, if the loans are non-
amortizing like in case of credit cards, some of these loans will still be paid off in whole or in part before the
maturity of the ABS. However, what happens after the loan is paid out depends on whether the loans were paid
off during the lockout period or after it. The lockout period is the period during which the principal repaid is
reinvested to acquire additional loans with a principal equal to the principal repaid.

Non-mortgage Asset-backed Securities (Cont.)
 Auto Loan ABS: The cash flows for auto loan-backed ABS consist of interest payments, scheduled principal
repayments, and any pre-payments. The pre-payments result from –
• Sales of vehicle which requires full payoff payment of the loan;
• Repossession and subsequent resale of autos;
• Insurance proceeds received upon loss or destruction of autos; and
• Early payoffs of the loans.
 Credit Card Receivables ABS: The cash flows from a pool of credit card receivables that consists finance
charges collected, fees, and principal repayments. The interest rate may be fixed or floating. As mentioned
earlier, these loans have lockout periods during which the cash flows consist of only collected finance
charges and fees. When the lockout period is over, the principal that is repaid by the cardholders is no longer
reinvested, and is distributed to the investors.

Collateralized Debt Obligations
 Collateralized Debt Obligations: This is a type of security backed by a diversified pool of one or more debt
obligations like:
• CDOs backed by corporate and emerging market bonds are Collateralized Bond Obligations (CBOs);
• CDOs backed by leveraged bank loans are Collateralized Loan Obligations (CLOs);
• CDOs backed by ABS, RMBS, CMBS, and other CDOs are structured finance CDOs; and
• CDOs backed by a portfolio of credit default swaps for other structured securities are synthetic CDOs.
 Structure: It involves the creation of an SPE, or special purpose entity. The CDO manager buys and sells
debt obligations for and from the portfolio of assets to generate sufficient cash flows to meet the obligations
to the CDO bondholders.
• The funds obtained from the issuance of debt obligations which have bond classes or tranches like senior bond
classes and subordinated bond classes, which is commonly referred to as the residual or equity tranches.
• The motivation to invest involves getting an exposure to debt products that investors may not otherwise be able
to purchase.
• Investors in equity tranches take more risk, and thus have the potential to earn an equity-type return.

Covered Bonds
Covered bonds are senior debt obligations issued by a financial institution, consisting of a segregated pool of
commercial and residential mortgages or public sector assets. These bonds are similar to ABS but offer
bondholders dual recourse – i.e., to both the issuing financial institution and the underlying pool of asset.
ABS often uses credit tranching to create bond classes with different borrower default exposures, covered bonds
usually consists of one bond class per cover pool. Also, in contrast to a strategic pool of mortgage loans exposing
investors to a prepayment risk (US mortgage backed securities), cover pool sponsors must replace any prepaid
or non-performing assets in the cover pool ensuring sufficient cash flows until the maturity of the covered bond.
 Hard Bullet covered bonds – A bond default is triggered if payments do not occur according to the original
schedule, bond payments are accelerated.
 Soft Bullet covered bonds – delay the bond default and payment acceleration of bond cash flows until a
new final maturity date, which is usually up to a year after the original maturity date.
 Conditional pass-through covered bonds – convert to pass-through securities after the original maturity
date if all bond payments have not been made yet.

Summary
1. Benefits of the securitization: Increase the liquidity and Reduce the funding costs.
2. Parties to a securitization: Seller of financial assets, a special purpose entity (SPE), and a servicer.
3. Time tranching: Classes that receive the principal payments when each prior tranche is repaid in full.
4. Key characteristics of RMBS include: Pass-through rate, Weighted average maturity and Conditional pre-payment rate.
5. External credit enhancement is a third-party guarantee.
6. Internal credit enhancement: Reserve funds, overcollateralization, and senior/subordinated structures.
7. Sequential-pay CMO: All scheduled principal payments and pre-payments are paid to each tranche in sequence until that
tranche is paid off.
8. Pre-payment risk: Uncertainty about the timing of the principal cash flows from an ABS.
9. Contraction risk: Risk that loan principal will be repaid more rapidly than expected.
10. Extension risk: Risk that loan principal will be repaid more slowly than expected.
11. Asset-backed securities may be backed by financial assets other than mortgages like auto loan and credit cards.
12. CDOs are structured securities backed by a pool of debt obligations.
13. PAC CMO receives predictable cash flows as long as the pre-payment rate remains within a pre-determined
range.
14. Covered Bonds have a dual recourse in nature with strict eligibility criteria, dynamic cover pool, and redemption regimes in the
event of sponsor default.

Knowledge Check

Knowledge Check
1. A non-conforming mortgage:
A. Cannot be used as collateral in a mortgage-backed security
B. Does not satisfy the underwriting standards for inclusion as collateral for an agency residential mortgage-
backed security
C. Does not give the lender a claim against the borrower for the shortfall between the amount of the outstanding
mortgage balance and the proceeds from the sale of the property in the event that the borrower defaults on the
mortgage
2. If a mortgage borrower makes pre-payments without penalty to take advantage of falling interest rates, the
lender will most likely experience:
A. Extension risk
B. Contraction risk
C. Yield maintenance
3. A pre-payment rate of 80 PSA means that investors can expect:
A. 80% of the par value of the mortgage pass-through security to be repaid prior to the security’s maturity
B. 80% of the borrowers whose mortgages are included in the collateral backing the mortgage passthrough
security to prepay their mortgages
C. The pre-payment rate of the mortgages included in the collateral backing the mortgage pass-through security to
be 80% of the monthly pre-payment rates forecasted by the PSA model

Solution
Solution: 1. B.
A non-conforming mortgage does not satisfy the underwriting standards for inclusion as collateral for an
agency residential mortgage-backed security
 Solution: 2. B.
If a mortgage borrower makes pre-payments without penalty to take advantage of falling interest rates, the
lender will most likely experience contraction risk.
 Solution: 3. C.
A pre-payment rate of 80 PSA means that investors can expect the pre-payment rate of the mortgages
included in the collateral backing the mortgage pass-through security to be 80% of the monthly pre-payment
rates forecasted by the PSA model.

Knowledge Check
4. A collateralized mortgage obligation:

A. Eliminates pre-payment risk
B. Is created from a pool of conforming loans
C. Redistributes various forms of pre-payment risk among different bond classes
5. The variability in the average life of the PAC tranche of a CMO relative to the average life of the mortgage
pass-through securities from which the CMO is created is:
A. Lower
B. The same
C. Higher
6. The tranche of a collateralized mortgage obligation that is most suitable for an investor who expects a fall in
interest rates is:
A. A fixed-rate tranche
B. An inverse floating-rate tranche
C. A PAC tranche

Solution
Solution: 4. C.
A collateralized mortgage obligation redistributes various forms of pre-payment risk among different bond
classes.
Solution: 5. A.
The variability in the average life of the PAC tranche of a CMO relative to the average life of the mortgage
pass-through securities from which the CMO is created is lower.
Solution: 6. B.
The tranche of a collateralized mortgage obligation that is most suitable for an investor who expects a fall in
interest rates is an inverse floating-rate tranche.

Knowledge Check
7. The investment that is most suitable for an investor who is willing and able to accept significant pre-payment
risk is:
A. A mortgage pass-through security
B. The support tranche of a collateralized mortgage obligation
C. The inverse floating-rate tranche of a collateralized mortgage obligation

Solution
Solution: 7. B.
The investment that is most suitable for an investor who is willing and able to accept significant pre-payment
risk is the support tranche of a collateralized mortgage obligation.

Reading 43: Understanding Fixed-Income Risk and Return

Learning Outcomes

a. Calculate and interpret the sources of return from investing in a fixed-rate bond;
b. Define, calculate, and interpret Macaulay, modified, and effective durations;
c. Explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;
d. Define key rate duration and describe the use of key rate durations in measuring the sensitivity of bonds to changes in
the shape of the benchmark yield curve;
e. Explain how a bond’s maturity, coupon, and yield level affect its interest rate risk;
f. Calculate the duration of a portfolio and explain the limitations of portfolio duration;
g. Calculate and interpret the money duration of a bond and price value of a basis point (PVBP);
h. Calculate and interpret approximate convexity and distinguish between approximate and effective convexity;
i. Estimate the percentage price change of a bond for a specified change in yield, given the bond’s approximate duration
and convexity;
j. Describe how the term structure of yield volatility affects the interest rate risk of a bond;
k. Describe the relationships among a bond’s holding period return, its duration, and the investment horizon;
l. Explain how changes in credit spread and liquidity affect yield-to-maturity of a bond and how duration and convexity
can be used to estimate the price effect of the changes.
m. Describe the difference between empirical duration and analytical duration.

Sources of Return
 Sources of Return: There are three sources of return from a fixed rate bond, namely:
• Coupon payments and Principal payments on the scheduled dates
• Income from reinvestment of coupon payments and
• Capital gains/losses on the sale of the bond prior to maturity.

Sources of Return (Cont.)
 Example 1:
• A 'buy-and-hold' investor purchases a 10-year, 8% annual coupon payment bond at 85.503075 per 100 of par
value and holds it until maturity. If the coupon payments are reinvested at 10.40%, the future value of the
coupons on the bond’s maturity date is 129.970678 per 100 of par value.
• The investor’s total return is 229.970678, the sum of the reinvested coupons (129.970678) and the redemption
of principal at maturity (100). The realized rate of return is 10.40%.
• Conclusion: It demonstrates that total return is equal to YTM when the investor holds the bond to maturity,
there is no default by the issuer, and the coupon interest payments are reinvested at that same rate of interest.

 Example 2:
• It considers another investor who buys the 10-year, 8% annual coupon payment bond and pays the same price.
37.347111
• After four years, when the bond is sold, it has six years remaining until maturity. If the yield-to maturity remains
10.40%, the sale price of the bond is 89.668770.
• Conclusion: This example demonstrates that the realized horizon yield matches the original yield-to-maturity if
coupon payments are reinvested at the same interest rate as the original yield-to-maturity, and the bond is sold
at a price on the constant-yield price trajectory
‒ Horizon Yield: Horizon yield is the Internal Rate of Return (IRR) between the total return (which includes
the sum of reinvested coupon payments and the sale price of the bond) and the purchase price of the
bond. It is the annualized holding-period rate of return of the bond.

Exhibit 1. Constant-Yield Price Trajectory for a 10-Year, 8%  A point on the trajectory or line is the carrying
Annual Payment Bond value of the bond at that time.
Price
 The carrying value is the purchase price plus the
102 amortized amount of the discount if the bond is
purchased at a price below par value and the
100
purchase price minus the amortized amount of
98 the premium if the bond was purchased at a
premium.
96
94 Capital Gain if the

Bond Is Sold at a
92 Price Above the
Trajectory
90
Capital Loss if the
Bond Is Sold at a
88 Price Below the
Trajectory
86
84
0 2 4 6 8 10
Year
 Example 3:
• Let’s assume that market discount rate on the bond increases from 10.40% to 11.40%. Coupon reinvestment
rates go up by 100 bps as well.
‒ The buy-and-hold investor purchases the 10-year, 8% annual payment bond at 85.503075. After the bond
is purchased and before the first coupon is received, interest rates go up to 11.40%. The future value of
the reinvested coupons at 11.40% for 10 years is 136.380195 per 100 of par value.
‒ The total return is 236.380195 (= 136.380195 + 100). The investor’s realized rate of return is 10.70%.
‒ Conclusion: In Example 3, the buy-and-hold investor benefits from the higher coupon reinvestment rate.
The realized horizon yield is 10.70%, 30 bps higher than the outcome in Example 1, when interest rates
are unchanged. There is no capital gain or loss because the bond is held until maturity. The carrying value
at the maturity date is par value, the same as the redemption amount.

I. Example 4:
• The investor buys the 10-year, 8% annual payment bond at 85.503075 and sells it in four years. After the bond is
purchased, interest rates go up to 11.40%. The future value of the reinvested coupons at 11.40% after four years
is 37.899724 per 100 of par value. The sale price of the bond after four years is 85.780408.
• The total return is 123.680132 (= 37.899724 + 85.780408), resulting in a realized four-year horizon yield of
9.67%.
• Conclusion: In Example 4, the investor has a lower realized rate of return compared with the investor in
Example 2, in which interest rates are unchanged. Notice that the capital loss is measured from the bond’s
carrying value and not from the original purchase price. The bond is now sold at a price below the constant-yield
price trajectory. The reduction in the realized four-year horizon yield from 10.40% to 9.67% is a result of the
capital loss being greater than reinvestment income.
• Broadly, we can say that, if the investment horizon is long-term then reinvestment income matters more
than capital gains and the investor would favor the interest rates to go up. However, if the investment
horizon is short-term, capital gains would matter more and the investor would want the interest rates to
go down.

Interest Rate Risk on Fixed-rate Bonds
Measures of Interest Rate Risk
Duration Convexity
Yield Duration Curve Duration
Macaulay Duration Effective Duration
Modified Duration
Money Duration
Price Value of Basis

Point

Interest Rate Risk on Fixed-rate Bonds (Cont.)
 Duration: It measures the sensitivity of the full price of the bond (flat price + accrued interest) to changes in
the bond’s YTM or changes in benchmark interest rates. This measure assumes that the variables other (like
time to maturity) than the YTM or benchmark rates are held constant.
• Yield Duration: It measures the sensitivity of the bond price with respect to the bond’s own YTM. The statistics
which measure this type of duration include Macaulay duration, modified duration, money duration, and the Price
Value of a Basis Point (PVBP).
• Curve Duration: It measures the sensitivity of the bond price with respect to a benchmark yield curve like the
government yield curve, the spot curve, or the forward curve. The statistic which measures this duration is
effective duration.
 Macaulay Duration: This measure calculates the weighted average of the time taken to receive the bond’s
promised payments. To put it simply, it is the weighted average number of years an investor must maintain a
position in the bond until the present value of the bond's cash flows equals the amount paid for the bond.

Period Cash Present Value Weight Period *Weight

Flow
1 8 7.246377 0.08475 0.0847
The first two columns show the number of
2 8 6.563747 0.07677 0.1535
periods to the receipt of the cash flow and the
3 8 5.945423 0.06953 0.2086 amount of the payment per 100 of par value.
4 8 5.385347 0.06298 0.2519 The third column is the present value of the
5 8 4.878032 0.05705 0.2853 cash flow. For example, the final payment is
6 8 4.418507 0.05168 0.3101
108 (the last coupon payment plus the
redemption of principal) and its present value
7 8 4.002271 0.04681 0.3277
is 40.154389.
8 8 3.625245 0.04240 0.3392
9 8 3.283737 0.03840 0.3456
10 108 40.154389 0.46963 4.6963
85.503075 1.00000 7.0029
The sum of the present values is the full price of the bond. The fourth column is the weight, the share of total
market value corresponding to each cash flow. The final payment of 108 per 100 of par value is 46.963% of
the bond’s market value.
The fifth column is the number of periods to the receipt of the cash flow (the first column) multiplied by the
weight (the fourth column). The sum of that column is 7.0029, which is the Macaulay duration of this 10-year,
8% annual coupon payment bond. This statistic is sometimes reported as 7.0029 years, although the time
frame is not needed in most applications.

 Macaulay Duration: Another approach to calculate Macaulay Duration is by using the below formula:
• The Macaulay duration of the 10-year, 8% annual payment bond is calculated by entering r = 0.1040, c =
0.0800, N = 10, and t/T = 0

 Modified Duration: It is very simple to calculate modified duration if we have the Macaulay Duration. Even
though it might seem to be a small adjustment to Macaulay Duration, Modified Duration provides and
important estimate which shows percentage price change for a bond, given a change in its YTM.
 For example, the Modified Duration of a bond with 7.0029 as Macaulay Duration and 10.4% as YTM will be
calculated as follows:
 Using the Modified Duration, the change in bond price with respect to change in yield can be calculated as
follows:
 The ≈ sign means that this calculation is an estimation. The minus sign signified that bond prices and YTM
move inversely. The price change in percentage refers to the full price, including the accrued interest.

I. For example – If the YTM of a bond with approximate modified duration of 6.126829 changes from 5% to
6%, the % change in PV is equal to:
II. Approximate modified duration can be calculated using the below formula:
For example – If the price increase when the interest rates go down by 5 bps is 81.12 and the price decrease when
the interest rates go up by 5 bps is 79.88 and current price of the bond is 80.50. The approximate modified durations
is calculated as:

I. Effective Duration: It is another approach to measure the interest rate risk of a bonds, which is the
percentage change in price given with respect to a change in a benchmark yield curve like the government
par curve. The formula to calculate it is very similar to effective duration.
I. Importance of Effective Duration: While measuring the interest rate risk of a complex bond (like callable
bond), effective duration is necessary. The main concern is that the future cash flows are uncertain as the bond
can be called depending upon the future interest rates. In short, a callable bond does not have a well-defined
internal rate of return or YTM and therefore, yield duration statistics, such as modified and Macaulay durations,
do not apply in such cases.
II. Key-rate Duration: It is a measure of a change in bond’s price to a change in the benchmark yield curve but at
a specific maturity segment.
III. For example – You may want to know by how much the price of the callable bond is expected to change if
benchmark rates at longer maturities (15 and above years) shifted up by 50 bps, but the shorter maturity
benchmark rates remained unchanged. It would represent a flattening of the yield curve and key rate duration
instead of effective duration will be used to bond’s sensitivity.

I. Properties of Bond Duration: the duration statistics for a fixed-rate bond depend on three factors:
I. Coupon rate: A higher coupon rate reduces the duration or sensitivity of a bond.
II. Yield-to-maturity: A higher yield-to maturity also reduces the duration or sensitivity of a bond.
III. Time-to-maturity: A longer time-to-maturity usually leads to a higher sensitivity or duration of a bond.

 Duration of a Bond Portfolio: Broadly, the duration of a bond portfolio can be calculated by two ways:
• The weighted average of time to receipt of the aggregate cash flows; this method is theoretically correct but
difficult to apply.
• The weighted average of the individual bond durations that comprise the portfolio; this method is easy to use but
has its limitations.
 Let us understand the difference between two approaches with the help of an example. Suppose an investor
holds the following portfolio of two zero-coupon bonds:
Bond Maturity Price Yield Macaulay Modified Par Value Market Weight
Duration Duration Value
(X) 1 year 98.00 2.0408% 1 0.980 10,000,000 9,800,000 0.50
(Y) 30 years 9.80 8.0503% 30 27.765 100,000,000 9,800,000 0.50
 First approach – The weighted average of time to receipt of the aggregate cash flows:
• Its cash flow yield is 7.8611%. Cash flow yield is calculated as:

• Using the following formula, the Macaulay duration and modified duration of the portfolio can be calculated:
• Limitations of this approach are as follows:

‒ Firstly, the cash flow yield is not available or calculated.
‒ Secondly, future coupon and principal payments are uncertain in case of callable or putable bonds.
‒ Thirdly, duration is usually expressed as a change in benchmark interest rates and not as a change in the
cash flow yield.
‒ Fourthly, the change in the cash flow yield is not necessarily the same as the change in the YTM. For
instance, if the YTM on the two zero-coupon bonds in this portfolio both changes by 100 bps, the cash flow
yield would change by only 90.52 bps.

 Second approach – Under this method, the portfolio duration is calculated as follows:
Average Macaulay duration = (1 0.50)+(30 0.50)=15.50
Average modified duration = (0.980 0.50)+(27.765 0.50)=14.3725
• It is the weighted average of the statistics for the individual bonds.
• The limitation of this approach is that it assumes the parallel shift in the yield curve.
 Money Duration of a Bond: The money duration or dollar duration of a bond shows the price change in
currency units in which the bond is denominated.
MoneyDur = AnnModDur PVFull
 Price value of a basis point: It is the estimate of the change in the full price with a 1 bps change in the
YTM. It can be calculated as follows:

 Bond Convexity: It is a measure of bond’s price sensitivity given a change in the YTM.
Price
Convex Price-Yield Curve
Estimated Change Due to Convexity
Estimated Change Due to Duration
Line Tangent to the

Price-Yield Curve
Yield-to-Maturity
 As we know that the true relationship between the bond price and the YTM is convex, as shown in the graph.
However, duration assumes a linear relationship so it is suitable to measure the sensitivity in the price for
smaller changes in interest rates (as long as the straight line is tangent to the curved line). Beyond that point,
we need convexity as a measure for correct estimation of sensitivity.

 Bond Convexity can be measured with the help of the following formula:
 The convexity of a zero coupon bond can be measured with the help of following formula:
• Where N is the number of periods to maturity as of the beginning of the current period, t/T is the fraction of the
period that has gone by, and r is the yield-to-maturity per period.
 The total change in the bond’s price with respect to interest rates is equal to the bond’s duration +
convexity.

Price
More Convex Curve
Less Convex Curve
Line Tangent to the

Price-Yield Curve
Yield-to-Maturity

Interest Rate Risk and the Investment Horizon
 Yield Volatility: The term structure of yield volatility is the relationship between the volatility of bond YTM
and times-to-maturity. The changes in bond prices are products of two factors. The first factor is duration and
convexity and the second factor is the yield volatility. For example, consider a 10-year bond with a modified
duration of 5 and a 30-year bond with a modified duration of 20. It is evident that the 30-year bond
represents more interest rate risk to an investor. In fact, the 30-year bond has four times the risk compared
to short-term bond. However, it does not mean that the 30-year bond might have four times the yield volatility
of the 10-year bond.
 Investment Horizon, Macaulay Duration, and Interest Rate Risk: As we showed earlier, if the investment
horizon is long-term then reinvestment income matters more than capital gains and the investor would favor
the interest rates to go up. Similarly, we can relate this conclusion to the Macaulay duration in the following
way:
• When the investment horizon is higher than the Macaulay duration of a bond, reinvestment risk dominates is
higher than market price risk.
• When the investment horizon is equal to the Macaulay duration of a bond are equal, reinvestment risk offsets
the market price risk.
• When the investment horizon is lower than the Macaulay duration of the bond, market price risk dominates the
reinvestment risk.

Credit and Liquidity Risk
 Credit risk is the probability of default and recovery rate, if default occurs. An example of credit risk is a
credit rating downgrade.
 Liquidity risk is the transaction costs associated with selling a bond. So a highly liquid bond with greater
frequency of trading would have less liquidity risk and less selling cost and vice-versa.

Empirical Duration
The approach taken in this reading to estimate duration and convexity statistics using mathematical formulas is
often referred to as analytical duration. These estimates of the impact of benchmark yield changes on bond
prices implicitly assume that government bond yields and spreads are independent variables that are
uncorrelated with one another. Analytical duration offers a reasonable approximation of the price–yield
relationship in many situations, but fixed-income professionals often use historical data in statistical models that
incorporate various factors affecting bond prices to calculate empirical duration estimates. These estimates
calculated over time and in
different interest rate environments inform the fixed-income portfolio decision-making process.

Summary
1. Sources of return from a bond: Coupon and principal payments, Reinvestment of coupon payments,
Capital gains or loss if bond is sold before maturity.
2. Macaulay duration: The number of weighted average number of coupon periods until a bond’s scheduled
cash flows.
3. Effective duration: Appropriate Suitable measure of interest rate sensitivity risk for bonds with embedded
options.
4. Key rate duration: It measures price sensitivity of a bond or a bond portfolio to a change in the spot rate for
a specific maturity.
5. Other things being constant duration increases when maturity increases, duration decreases when the
coupon rate increases, duration decreases when YTM increases.
6. Methods of calculating portfolio duration: 1. Calculate the weighted average number of periods until cash
flows will be received and 2. Calculate the weighted average of durations of bonds in the portfolio.
7. Convexity: Curvature of a bond’s price-yield yield curve is convexity.
8. Term structure of yield volatility: Relationship between maturity and yield volatility Graph showing maturity
and yield volatility is the term structure of yield volatility.

Summary
9. Over a short investment horizon: A change in YTM affects market price more than it affects the
reinvestment income. Market price is more sensitive to YTM than investment income.
10. Over a long investment horizon: a change in YTM affects reinvestment income more than it affects the
market price. Investment income is more sensitive to YTM than market price.
11. Yield Spread: This includes a premium for credit risk and a premium for illiquidity.

Knowledge Check

Knowledge Check
1. A bond is currently trading for 98.722 per 100 of par value. If the bond’s YTM rises by 10 basis points, the
bond’s full price is expected to fall to 98.669. If the bond’s YTM decreases by 10 basis points, the bond’s full
price is expected to increase to 98.782. The bond’s approximate convexity is closest to:
A. 0.071
B. 70.906
C. 1,144.628
2. A bond has an annual modified duration of 7.020 and annual convexity of 65.180. If the bond’s yield-to-
maturity decreases by 25 basis points, the expected percentage price change is the closest to:
A. 1.73%
B. 1.76%
C. 1.78%
3. A manufacturing company receives a ratings upgrade and the price increases on its fixed-rate bond. The
price increase was most likely caused by a(n):
A. Decrease in the bond’s credit spread
B. Increase in the bond’s liquidity spread
C. Increase of the bond’s underlying benchmark rate

Solution
 Solution: 1. B.
Convexity = (98.782 + 98.669 – 2 98.722) / (.001 .001 98.722) = 70.906
 Solution: 2. C.
Expected price change = -(7.02 -.0025) + ( 0.5 65.18 .0025 .0025) = 0.01775 = 1.78%
 Solution: 3. A.
A manufacturing company receives a ratings upgrade and the price increases on its fixed-rate bond. The
price increase was most likely caused by a decrease in the bond’s credit spread.

Knowledge Check
4. An investor purchases a bond at a price above par value. Two years later, the investor sells the bond. The
resulting capital gain or loss is measured by comparing the price at which the bond is sold to the:
A. carrying value.
B. original purchase price.
C. original purchase price value plus the amortized amount of the premium.

Solution
 Solution: 4. B.
The future value of reinvested cash flows at 8% after five years is closest to 41.07per 100 of par value.
The 6.07 difference between the sum of the coupon payments over the five- year holding period (35) and the
future value of the reinvested coupons (41.07) represents the “interest- on- interest” gain from compounding.

Knowledge Check
The following information relates to Problems 5–7

An investor purchases a nine- year, 7% annual coupon payment bond at a price equal to par value. After the
bond is purchased and before the first coupon is received, interest rates increase to 8%. The investor sells the
bond after five years. Assume that interest rates remain unchanged at 8% over the five- year holding period.
5. Per 100 of par value, the future value of the reinvested coupon payments at the end of the holding period is
closest to:
A. 35.00.
B. 40.26.
C. 41.07.
6. The capital gain/loss per 100 of par value resulting from the sale of the bond at the end of the five- year
holding period is closest to a:
A. loss of 8.45.
B. loss of 3.31.
C. gain of 2.75.
7. Assuming that all coupons are reinvested over the holding period, the investor’s five- year horizon yield is
closest to:
A. 5.66%.
B. 6.62%.
C. 7.12%.

Solution
 Solution: 5. B.
The capital loss is closest to 3.31 per 100 of par value. After five years, the bond has four years remaining
until maturity and the sale price of the bond is 96.69, calculated as:
The investor purchased the bond at a price equal to par value (100). Because the bond was purchased at a
price equal to its par value, the carrying value is par value. Therefore, the investor experienced a capital loss
of 96.69 – 100 = –3.31.
 Solution: 6. B.
The investor’s five- year horizon yield is closest to 6.62%. After five years, the sale price of the bond is 96.69
(from problem 5) and the future value of reinvested cash flows at 8% is 41.0662 (from problem 4) per 100 of
par value. The total return is 137.76 (= 41.07 + 96.69), resulting in a realized five- year horizon yield of
6.62%:

Solution
 Solution: 7. A.
The bond’s approximate modified duration is closest to 2.78.
Approximate modified duration is calculated as:
Lower yield- to- maturity by 5 bps to 2.95%:
Increase yield- to- maturity by 5 bps to 3.05%:
PV0 = 105.657223, ΔYield = 0.0005

Reading 44: Fundamentals of Credit Analysis

Learning Outcomes

a. Describe credit risk and credit-related risks affecting corporate bonds;
b. Describe default probability and loss severity as components of credit risk;
c. Describe seniority rankings of corporate debt and explain the potential violation of the priority of claims in a
bankruptcy proceeding;
d. Compare and contrast corporate issuer credit ratings and issue credit ratings and describe the rating agency
practice of 'notching';
e. Explain risks in relying on ratings from credit rating agencies;
f. Explain the four Cs (Capacity, Collateral, Covenants, and Character) of traditional credit analysis;
g. Calculate and interpret financial ratios used in credit analysis;
h. Evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial ratios of
the issuer and the industry;
i. Describe macroeconomic, market, and issuer-specific factors that influence the level and volatility of yield
spreads;
j. Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign
government debt issuers and issues.

Credit Risk
 Credit risk: It is the risk of loss as a result of borrower failing to make full and timely payments. It has two
components:
• Default risk or probability: This is the probability that a borrower defaults.
• Loss severity: It is the portion of a bond’s value that an investor loses. For example, 45% of loss severity would
mean, 55% of the bond’s value or principal is not returned by the borrower. That 55% can also be termed as the
recovery rate.
Expected loss = Default probability Loss severity given default
 The credit risk can be divided into three categories:
• Spread risk: The difference between the yield of a risky bond and a non-risky bond is termed as spread risk.
• Credit migration risk or downgrade risk: The risk of issuer’s creditworthiness deteriorating, leading to a rating
downgrade and making investors believe the risk of default is higher is known as downgrade risk.
• Market liquidity risk: Sometimes, the price at which investors can actually transact might differ from the price
indicated in the market as a result of insufficient liquidity.

Capital Structure, Seniority Ranking, and Recovery Rates
 Capital Structure: This is the 'structure' of a company’s or institute’s liabilities. It is composed of debt,
preference shares, equity shares, etc.
 Seniority Ranking: It represents priority of payment priority starting with the most senior or highest-ranking
debt having the first claim on the cash flows and assets of the issuer debt to junior debt.
Secured Debt Unsecured Debt

Direct claim by debt holder on issuer’s assets cash flow Only a general claim
Priority of claims Claims rank below in case of default
 First Mortgage Debt: It includes pledge of a specific property like power plant.
 First lien debt: It includes pledge of certain assets like patents and licenses.
 Subordinated debt: It includes the junior debt which might have little or no recovery in case of default.

(Cont.)
First Lien Loan
Senior Secured
Senior Unsecured
Senior Subordinated
Subordinated
Junior Subordinated

Capital Structure, Seniority Ranking, and Recovery Rates (Cont.)
 Recovery Rates: It is defined as the price of the bond immediately after default as a % of its face value.
Recovery rate = 1 - loss severity.
 Pari Passu: All the creditors with same capital structure are treated as one class. For example, a senior
unsecured bondholder whose debt is due in 10 years has the same pro rata claim in bankruptcy as another
senior unsecured bondholder whose debt matures in three months.
 This provision is referred to as bonds ranking pari passu ('on an equal footing’)
 Recovery Rates: There are a few things pertaining to recovery rates worth noting:
• Recovery rates can vary widely by industry: Some industries may have lower recovery rates than the other.
For instance, the companies that go bankrupt due to secular decline, like DVD manufacturing may have lower
recovery rates.
• Recovery rates can also vary depending on when they occur in a credit cycle: Recovery rates are
generally lower at the bottom of the credit cycle as many companies are defaulting at that time.
• The recovery rates are averages: There can be a large variability in recovery rates across industries.
Moreover, different companies have different debt structure. So the public data on recovery rates is an average
of various industries and issues.

Capital Structure, Seniority Ranking, and Recovery Rates (Cont.)
 Priority of claims: The priority of claims is not always absolute which means that it is not necessary that the
highest-ranked creditors get paid out first, followed by the next level, and on down, like a waterfall. Generally,
in the event of bankruptcy:
• Secured debt holders have the right to the value of that specific property before any other claim. However, if the
value of the pledged property is less than the amount of the claim, then the difference becomes a senior
unsecured claim.
• Unsecured creditors have a right to be paid the full amount before the holders of equity.
• Senior unsecured creditors are paid before subordinated creditors.

(Cont.)
 Credit Ratings Agencies: The major credit rating agencies are: Moody’s Investors Service (Moody’s),
Standard and Poor’s (S&P), Fitch Ratings (Fitch).
 Credit rating agencies are getting prominence due to:

• Independent assessment of credit risk;
• Ease of comparison across bond issuers, issues and market segments;
• Regulatory and statutory reliance and usage;
• Payment by issuer for ratings;
• Growth of debt markets and
• Development and expansion of bond portfolio management and the accompanying bond indexes.
 With exceptions of the subprime mortgage crisis, rating agencies have shown that they do a good job rating
debt. However, there are risks involved in relying solely on credit rating agencies:
• Credit ratings can change over time;
• Credit ratings tend to lag the market’s pricing of credit risk and
• Rating agencies may make mistakes: Some risks are difficult to capture in credit ratings.

(Cont.)
 Issuer Credit Rating – Corporate Family Rating (CFR). An opinion of the obligator's overall
creditworthiness. It takes into account both ability and willingness of the issuer.
 Issue Credit Rating – Corporate Credit Rating (CCR).It refers to specific financial obligation of an issuer.
This takes into account the capital structure.
 Cross Default Provisions – If interest or principal payments are not serviced for one debt issue, then it
triggers default on all debt issues.
 Notching – Since there are different payment priorities, the potential for loss for would also differ in the event
of default. So the rating agencies have adopted a notching process, whereby their credit ratings on issues
can be moved up or down from the issuer rating, which is usually the rating applied to its senior unsecured
debt. The higher the senior unsecured rating, the smaller the notching adjustment will be. The reason behind
this is that the higher the rating, the lower the perceived risk of default, so the need to 'notch' the rating to
capture the potential difference in loss severity is greatly reduced.
 Structural Subordination – Debt of a subsidiary would get serviced by the subsidiary before funds could be
passed on to the parent company.

Traditional Credit Analysis: Corporate Debt Securities
 Unlike equity shareholders, the bondholders do not share the upside and face only downside risk.
 As such, credit analysts are concerned about the fund’s safety and sustainability of cash flows.
Components of credit analysis
Character  This refers to management's honesty and willingness to repay the debt.
 Rating agency gives due weightage to corporate governance practices like large and effective team of
board of directors with more number of independent directors. Board should have enough resources and
powers to fulfill their duties toward shareholders. Board should not be chaired by any management
representative to minimize the conflict of interests.
Covenants  Terms and conditions on which lenders have agreed to lend or participate in debt issue, affirmative
covenants require management to act on certain issues like regular payment of interests. Negative
covenants forbid management from taking any actions which could affect debtors' interests.
Collateral  Collateral is pledging of specific assets to a lender, to secure the repayment of loan.
 Valuation of the collateral property or collateral analysis is an important part.
Capacity to pay  Ability to generate enough cash flow in order to service its debt obligations is the capacity to pay.
 Firm's capacity to repay is assessed by its solvency ratios, high solvency ratios indicate a greater capacity
to repay.
 Industry structure/fundamentals, such as bargaining power of buyer/supplier, barriers to entry, competition,
growth prospects, cyclicality, etc. are the important factors to access the capacity.
 Apart from the financial position, sources of liquidity, company structure, guarantees from parent company,
etc. should also be analyzed.

Traditional Credit Analysis: Corporate Debt Securities (Cont.)
Credit Analysis Ratios can be classified into 3 groups:

Profitability and Cash Flow:
• EBITDA, FFO, Free cash flow before dividends, Free cash flow after dividends
Leverage ratios: Lower the better. Measures the relative contribution of stockholders and creditors.
• Debt/Capital, Debt/EBITDA, FFO/Debt
Coverage: Indicates a company's capacity to meet interest payments.
• EBITDA/Interest and EBIT/Interest
Other factors considered by the credit analysts include:
• Capex commitment;
• Debt payment schedule;
• Current cash position;
• Operating cash flows;
• Committed bank lines and
• Net working capital.

Credit Risk vs Return: Yields and Spreads
 Lower the credit quality, higher the quoted yield.

Return (%)
120
90
60
30
-30
-60
Aaa Aa A Baa Ba B Caa
Avg. Return 6.18% 6.63% 6.52% 7.33% 8.58% 6.93% 8.10%

Max Return 16.08% 19.30% 29.39% 36.43% 50.80% 52.10% 91.47%
Min Return -4.17% -5.47% -14.98% -15.70% -22.12% -31.47% -44.35%
Avg. Volatility 4.02% 4.45% 5.18% 5.51% 6.31% 8.11% 12.63%

Credit Risk vs Return: Yields and Spreads
 Yield on corporate bond = Real risk free interest rate + Expected inflation rate + Maturity premium +
Liquidity premium + Credit spread
 Yield Spread = Liquidity premium + Credit spread
 Factors Affecting the Spread Volatility of a Corporate Bond:
• Credit Cycle
‒ Spreads are the widest at the bottom of the credit cycle
• Broader Economic Conditions
‒ Strengthening economy causes spreads to contract and vice-versa
‒ Financial Market Performance
‒ In a steady, low volatility environment, credit spreads are typically narrow
• Willingness of Broker–Dealers to provide sufficient capital for market making
‒ More capital available increases liquidity
• Broker–dealers’ willingness to provide sufficient capital for market making.
‒ During the financial crisis, several large broker–dealer counterparties either fail as a result of which there
are not sufficient resources for market making
• General Market Demand and Supply
‒ In situations where there is an oversupply of corporate bonds, credit spreads widen.

Special Considerations of High-yield, Sovereign, and Non-sovereign Credit Analysis
 Analysis of High Yield (Junk Bonds): Bonds rated below Baa3/BBB
 Reasons for below investment grade rating:

• Leveraged capital structure
• Limited operating history
• Small or negative free cash flow
• Highly cyclical business
• Poor management
• Risky financial policies
• Lack of scale and competitive advantages
• Large off-balance-sheet liabilities
• Declining industry

Special Considerations of High-yield, Sovereign, and Non-sovereign Credit Analysis (Cont.)
 Special considerations for high-yield analysis

• Greater focus on Issuer liquidity and cash flow
• Detailed Financial projections in detail
• Analysis of the Debt structure analysis
• Understanding of a issuer’s corporate structure
• Covenants
• Equity like approach to high yield analysis
 Financial Projections: To project future earnings and cash flows to assess issuer’s credit profile. Should
account for committed capex, working capital change and dept payment schedule. It is important to go
through Stress Scenario analysis
 Liquidity : Sources of liquidity, from strongest to weakest are:
• Cash on balance sheet
• Working capital
• Operating cash flows
• Bank credit facilities
• Equity issuance

 Debt Structure: The high-yield issuer will some of the following types of obligations in its debt structure:
• (Secured) Bank debt
• Second lien debt
• Senior unsecured debt
• Subordinated debt, which may include convertible bonds
• Preferred stock
 Corporate structure
• Generally, debt is obtained at holding Company level, whereas operating cash flow comes from the subsidiary.
Hence, credit risk on high yield securities at holding company level increases if:
‒ There are restrictions on dividend payments to parent company in the debt covenants of subsidiary
‒ Asset sales is prohibited

 Covenant Analysis: Key covenants are

• Change of control put: During acquirement, bondholders have right to require issuer to buy back their debt at
par or small premium at par value
• Restricted payments: Limits how much cash can be paid to shareholders
• Limitations on liens: Limits on how much secured debt an issuer can have
 Sovereign Debt Analysis: Sovereign ratings are debt rating of national governments
 Two sovereign ratings are assigned to each government, i.e., one is local currency rating and another is
foreign currency rating

 General categories which are analysed in deciding the sovereign rating:

• Economic Risk
‒ Ability of government to repay its financial obligation
‒ Economic and income structure, e.g. – composition of economy, living standards, income growth, etc.
‒ Balance of payments flexibility, e.g. – structure of current a/c, impacts of fiscal monetary policies, etc.
‒ External debt and liquidity, e.g. – size of public external debt, debt service track record and composition of
reserves, etc.
‒ Economic growth prospects, e.g. – composition of savings and investments, pattern of economic growth,
etc.
‒ Fiscal flexibility, e.g. – tax raising flexibility, operating and total budget balance, etc.
• Political Risk
‒ Form of government, political structure and stability of political institutions
‒ Internal and external security risks
‒ Integration in global trade and financial system
‒ Orderliness of leadership succession

 Bonds issued by local municipalities and backed by some form of tax revenue:
• Issuer's debt structure – Debt burden measured as per capita debt as well as debt as % of the real estate
properties and personal income, which are subject to property and income tax
• Budgetary policy – It is a manifesto of financial and political discipline
• Local tax intergovernmental revenue availability – Historical tax collection numbers and state government
guarantee helps in deciding repayment capacity of municipality
• Issuer's socioeconomic environment – Local employment level, economic and business environment helps in
assessing the stability of revenue and future earnings
 To finance some projects, municipalities issue revenue bonds and securitize the future revenue likely to be
generated from this project:
• Limits of the basic security – Indenture guidelines explains the use of project revenue and any limitations on that
reduces bond's credit rating
• Flow of fund structure – Revenue bonds are backed by net revenues after deducting operating expenses.
Expenses which are non-operating in nature, but still classified under operating expenses will reduce the credit
quality of revenue bonds
• Priority of revenue claims – First claim on the project cash flow will determine the credit quality
• Additional bonds test – Conditions under which the municipality can issue additional debt. Tighter the restrictions
higher the credit quality of the revenue bond

Summary
 Spread risk: This is the possibility that a bond loses value because its credit spread widens.
 Credit risk: Default risk, which is the probability of default, and loss severity is credit risk.
 Corporate debt is ranked by seniority or priority of claims. Secured debt is a direct claim on specific firm
assets.
 Issuer credit ratings reflect a debt issuer’s overall creditworthiness.
 High yield bonds are more likely to default than investment grade bonds are the ones in which default risk
is higher.
 Credit risk of sovereign debt includes the issuing country’s ability and willingness to pay.
 Corporate bond yields = Real risk-free rate + expected inflation rate + credit spread + maturity premium +
liquidity premium.
 Lower credit risk = Lower leverage, higher interest coverage, and greater free cash flow form the lower
credit risk.
 Profitability refers to operating income and operating profit margin.
 Leverage ratios: This includes debt-to-capital, debt-to-EBITDA, and FFO-to-debt.
 Coverage ratios: These include the EBIT-to-interest expense and EBITDA-to-interest expense.

Knowledge Check

Knowledge Check
1. Using the S&P ratings scale, investment grade bonds carry which of the following ratings?
A. AAA to EEE
B. BBB– to CCC
C. AAA to BBB–
2. Using both Moody’s and S&P ratings, which of the following pairs of ratings is considered high yield, also
known as 'below investment grade,' 'speculative grade,' or 'junk'?
A. Baa1/BBB–
B. B3/CCC+
C. Baa3/BB+
3. What is the difference between an issuer rating and an issue rating?
A. The issuer rating applies to all of an issuer’s bonds, whereas the issue rating considers a bond’s seniority
ranking
B. The issuer rating is an assessment of an issuer’s overall creditworthiness, whereas the issue rating is always
higher than the issuer rating
C. The issuer rating is an assessment of an issuer’s overall creditworthiness, typically reflected as the senior
unsecured rating, whereas the issue rating considers a bond’s seniority ranking (e.g., secured or subordinated)

Solution
 Solution: 1. C.
Using the S&P ratings scale, investment grade bonds carry the AAA to BBB– ratings.
 Solution: 2. B.
Using both Moody’s and S&P ratings B3/CCC+ are considered the high yield rating.
 Solution: 3. C.
The issuer rating is an assessment of an issuer’s overall creditworthiness, typically reflected as the senior
unsecured rating, whereas the issue rating considers a bond’s seniority ranking (e.g., secured or
subordinated).

Knowledge Check
4. Based on the practice of notching by the rating agencies, a subordinated bond from a company with an
issuer rating of BB would likely carry what rating?
A. B+
B. BB
C. BBB–
5. The fixed-income portfolio manager you work with asked you why a bond from an issuer you cover didn’t rise
in price when it was upgraded by Fitch from B+ to BB. Which of the following is the most likely explanation?
A. Bond prices never react to rating changes
B. The bond doesn’t trade often so the price has not adjusted to the rating change yet
C. The market was expecting the rating change, and so it was already 'priced in' to the bond
6. Amalgamated Corp. and Widget Corp each have bonds outstanding with similar coupons and maturity dates.
Both bonds are rated B2, B–, and B by Moody’s, S&P, and Fitch, respectively. The bonds, however, trade at
very different prices—the Amalgamated bond trades at €89, whereas the Widget bond trades at €62. What is
the most likely explanation of the price (and yield) difference?
A. Widget’s credit ratings are lagging the market’s assessment of the company’s credit deterioration
B. The bonds have similar risks of default (as reflected in the ratings), but the market believes the Amalgamated
bond has a higher expected loss in the event of default
C. The bonds have similar risks of default (as reflected in the ratings), but the market believes the Widget bond
has a higher expected recovery rate in the event of default
Solution
 Solution: 4. A.
B+ is the likely ratings to be carried under the given circumstances.
 Solution: 5. C.
The market was expecting the rating change, and so it was already 'priced in' to the bond is the most likely
explanation.
 Solution: 6. A.
Widget’s credit ratings are lagging the market’s assessment of the company’s credit deterioration is the most
likely explanation of the price (and yield) difference.

Thank You!
For queries, write to us at: [email protected]

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc.

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 Reading 42: Introduction to Asset-backed Securities

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The candidate should be able to:

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An Example of a Securitization (asset backed securities)

3. Cash payments 2. Sale of the 6. Periodic cash

Medical Equipment Trust (MET)

4. Issuance and 5. Cash payment 6. Periodic cash

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 An Example of a Securitization (Mediquip)

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 An Example of a Securitization (Mediquip) Cont.

 Parties to a Securitization and their Roles:

• The seller of the collateral (Mediquip);

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Bond Class Par Value (US$ millions)

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 Key Role of the Special Purpose Entity –

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 Benefits for Investors:

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Bond Class Par Value (€ millions)

Bond Class A is given an investment-grade credit rating by the credit-rating agencies.

The correct answer is C.

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A diagram showing the structure of Mortgage Pass-through Securities:

Pass-through securities backed by the pool

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An example on WAC and WAM:

Outstanding Mortgage Balance Coupon Rate Number of Months to

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The WAC is:

The WAM is:

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Tranche Par Amount (US$ millions) Coupon Rate (%)

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Average Life (years)

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Tranche Par Amount (US$million) Coupon Rate (%)

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Average Life (years)

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